Fueling the operators

Although some private equity firms are resisting the fashion, operating partners have become the must-have accessory of today’s market.
Limited partners look for operating expertise at a private equity firm as returns from financial engineering seem to be nearing an expiration date. General partners realize this, as well as the difficulty in sourcing and winning deals without an industry insider. Therefore, operating partners are currently in great demand. Happily for the industry, former CEOs and other senior executives are equally attracted to the private equity opportunity, although these operating ets will hear different answers to the question: “What’s in it for me?”
Models of operating partner compensation vary greatly. Some are deployed as part-time consultants who swoop down to work on a deal and receive some options in the process. Others are full partners at a private equity firm and participate in the economics of every deal, regardless of which portfolio companies they have spent the most time on.
There is no standard definition of these operators. At some firms, they are called operating partners; at others, industry partners, operating executives, executive directors, or for venture firms, entrepreneurs-in-residence.
Depending on their expertise, these professionals will be involved in some or all of the stages of the life of an investment, from sourcing targets, conducting due diligence, handling operations, advising the portfolio company, and staying engaged right up to the exit of an investment.
Simon Francis, partner at executive search firm Christian and Timbers in Menlo Park, California, says that private equity firms tend to employ operating professionals who have one of three broad profiles.
First, private equity firms are hiring financial experts who have a track record of doing turnarounds. Francis cites the example of Jerry York, who was hired by Kirk Kerkorian to instigate change at the troubled General Motors. York was formerly the chief financial officer credited with turning around Chrysler with Lee Iacocca before moving on to fix IBM’s internal processes under Louis Gertsner. At GM, in less than a year, York influenced the car maker to halve its dividend payments and cut the salaries of its top executives and board members. (He has since left GM).
Second, former management consultants with the strategic, analytical and communication skills to understand the internal processes of a company are being recruited to improve shareholder value. In other words, their mandate is to drive transformation. Francis says that these individuals sometimes work full time at portfolio companies as chief strategy or restructuring officer, or spend a couple of days each week with the management team.
The third category is that of the semi-retired, former chief executives who provide interim leadership to portfolio
companies upon acquisition. These are the individuals who have “been there, done that” several times over and know the industry inside and out, such as Mickey Drexler, who ran Ann Taylor Stores Corp. and Gap Inc. before being tapped by Texas Pacific Group to head J. Crew Group.
There is a clear trend in the operator market. Francis says that operating partners are increasingly coming inhouse:
“[Private equity firms are] saying, ‘come be a permanent part of a team,’ rather than hiring them for spontaneous, ad-hoc consulting assignments.”
The opportunity to be a true partner at a private equity firm appeals to many operators. John Dillon says that following his retirement from International Paper as chairman and chief executive, he decided he “didn’t need to go to the beach” and so explored possible arrangements with several private equity firms. But rather than be “in a stable of CEOs” and do work that was “more episodic than I wanted,” Dillon joined New York-based Evercore Partners, hich offered him the chance to become a vice chairman and senior managing director.
“I didn’t want to be a consultant per se, but more a coach, mentor and problem solver,” says Dillon. “At Evercore, I sit on the investment committee and get a chance to talk about what’s going on at company A, B and C.”

How much, who pays?
Each private equity firm that uses operating partners seems to have its own model for compensating those partners, as shown by few private equity firms who have shared their operating partner models and economics with us (see boxes).
Operators with advisory or consulting assignments are usually paid a salary, and sometimes a bonus. Those who sit full time at the portfolio company are paid by that company.
But operating partners who work across a portfolio of companies or who advise fund professionals may be paid by the private equity firm, out of management fees.
Christian and Timbers’ Francis says that operating partners can receive anywhere from $750,000 to $1.5 million in cash compensation per year, but it is equity that makes these relationships complex. There is carried interest, but also the potential for getting equity in the portfolio company in the form of stock options, restricted stock or warrants, as well as the opportunity to co-invest in the deal.
Private equity firms are becoming more sophisticated in how to award compensation to operators. Not only is equity dangled as a powerful incentive, but the amount of equity is also awarded strategically. Michael Segal, partner at law firm Paul, Weiss, Rifkin, Wharton & Garrison in New York, says that performance-based vesting is becoming increasingly common.
“It’s typical for half or more of a manager’s equity to be subject to some sort of performance vesting, not just the passage of time,” says Segal. “Sometimes it might be an operating target such as EBITDA set by the board every year. But often the performance target is the return to the private equity investors, who are saying, ‘We don’t really are about the cash flow targets, all we care about is how much money our investors get back from this company and that’s going to be your performance target.’”
This trend toward performance-based vesting became more pronounced when US accounting rules changed in early 2006, says Andrew Gibson, Atlanta-based tax partner at law firm BDO Seidman. Unlike the prior rule where performance vesting could cause variable accounting treatment the amount of expense, the new rule introduces more certainty in financial statements.
Gibson explains, “under the new FAS 123R, the amount of expense is determined on the grant date and then is spread over the vesting period but will not change based on the stock price changing.”
As more operating partners become employees of private equity firms, some are given carried interest on top of cash and equity in individual portfolio companies.
Operating partners with long term relationships with the private equity firm may get carried interest in the fund.
Those with advisor or consultant-type relationships may be given preferential investment in deals by way of a “friends and family” fund, which does not pay carry or management fees. But this form of compensation is usually awarded only when the operating partners have proven themselves, which may take one to two years.
Potential complications in structuring operator compensation include delineating who gets credit for a company’s success – the operating partner or someone else.
In the event of a failure, firing an operating partner creates questions as to what the exit package should be. Indeed, deciding how to pay an operator for success is complicated enough.

David Snow and Rob Kotecki also contributed to this article